Delaying Social Security Is the Best Inflation Hedge

What’s the best way for investors to protect themselves against inflation fears?

MICHAEL KITCES: Prospective and early retirees have a decision to make about when to begin Social Security benefits. They are eligible for a full benefit at normal retirement age, a reduced benefit for starting early, and can earn delayed retirement credits for starting later. In essence, every year that Social Security benefits are delayed, a trade-off occurs: Forego the money in your (in the form of benefits paid) for the upcoming year, in exchange for getting higher benefits every year thereafter.

The initial trade-off is relatively straightforward. For an individual who can get a $1,000-per-month benefit at full retirement age, waiting a year earns an 8% delayed retirement credit, making future benefits higher by $80 per month… in exchange for not getting $12,000 in pocket through the year ($1,000 per month for 12 months). Accordingly, if we make some assumptions about how that $12,000 could have been invested (or the $12,000 that could have stayed invested if retirement spending could have been funded from Social Security benefits), we can figure out how many extra $80-per-month payments it takes to recover the $12,000 (plus growth). At some point, there is a “breakeven” where the higher payments exceed what was given up initially; if you think you’ll live past that point, the winning decision is to delay.

But there’s an additional layer to the decision that’s often forgotten: Social Security benefits receive an annual cost-of-living adjustment (COLA) to increase benefits for inflation. Which means delaying that $12,000 isn’t just about getting an extra $80 per month. It’s about getting an extra $80 per month increasing annually thereafter for inflation.

If inflation turns out to be 3% (and we assume growth is 6%), it takes about 17 years to recover the foregone $12,000 plus growth. By the 17-year mark, though, the “extra” payments are up to $132 per month (on top of the original $1,000-per-month benefit, which will have grown to $1,652 per month by that time).

If inflation turns out to be 6%, on the other hand, the breakeven is far different. Now it only takes 14 years to break even, and by that point the inflation-adjusted “extra” payments are already up to $181 per month!

In fact, as shown in the chart, what we find is that the higher inflation turns out to be (or the worse the portfolio’s growth rate), the shorter the breakeven period turns out to be, and the better the economic value of the decision to delay Social Security. Which means in practice, the decision for retirees to delay Social Security turns out to be a fantastic triple hedge–protecting against both unanticipated longevity (since payments continue for life), mediocre market performance and the risk of unexpected inflation.